1. Field of the Invention
The present invention relates generally to financial management systems, and more particularly to collateral management systems for trading groups.
2. Related Art
In the financial industry, two parties typically engage in a transaction, for example, where one party A loans money to another party B. Parties A and B can be individuals, corporations, financial institutions, or the like. Upon lending money to party B, party A exposes itself to the risk of B's default—B's failure to promptly pay interest or principal on the loan when due. In order for A to protect itself against the risk of B defaulting on the loan, A will usually require B to post collateral. Generally speaking, collateral are certain assets belonging to a borrower (i.e., party B), that are set aside and pledged to a lender (i.e., party A) for the duration of a loan. If the borrower fails to meet its obligations to pay principal or interest, the lender has claim to the assets.
In another example, party A may wish to protect itself from B defaulting on a forward contract. Forward contracts, as is well known in the relevant art(s), are agreements to buy or sell a particular type and grade of commodity at a particular price for delivery at an agreed-upon place and time in the future. The subject commodity of the forward contract can be any commonly traded bulk good (e.g., a particular crop, livestock, oil, gas, metals, t-bills, foreign exchange rate, etc.). The failure to perform by a buyer or a seller on a forward contract as required by the terms of the contract is another form of default.
Collateral is a simple way for party A to protect against the risk of the default on an obligation by a counterparty (i.e., party B). If a counterparty has posted collateral, then the collateral can be taken to offset the loss due to the default. Collateral can be posted based on two types of obligations: actual and potential. When collateral is posted to cover an actual exposure (i.e., a loss that has already occurred on a position but has not yet been settled), it is called “mark to market” (MTM) collateral. If collateral is posted to cover potential losses that have not yet occurred, it is called “anticipatory” collateral.
A “position” refers to the amount of a security or commodity (e.g., note, stock, bond, commodity option contracts, etc.) either owned or owed by a party. If a security is owned by a party, it is referred to as a “long” position with respect to that party. In contrast, if a security is owed by a party, it is referred to as a “short” position with respect to that party.
A typical company (e.g., party A) that undertakes trades, can have existing trades in place with a large number of counterparties. Referring to FIG. 1A, a block diagram illustrating such a network of obligations 100 (e.g., a trading system) from the perspective of Company A is shown. Each line within FIG. 1A represents an active portfolio of obligations between Company A and a specific counterparty. Company A has existing trades with counterparties B, C, D, E, F, and G, as shown in FIG. 1A. Company A “sees” only the part of the network 100 in which it is directly involved. The complete network 100, however, is more complex and can be represented by FIG. 1B. FIG. 1B is a block diagram illustrating the complete network 100 and depicts all of the interactions among the participants throughout the entire network.
To protect itself from credit losses, Company A could obtain collateral from its counterparties (i.e., counterparties B, C, D, E, F, and G). Each collateral interaction follows the same lines as the trade interactions shown in FIG. 1A. Mark to market collateral is posted by the counterparty who has an MTM loss on its portfolio. Hence, for every trading pair, one of the two counterparties should be posting collateral. This simply protects against a loss that has already occurred. However, any risky position has the potential for future losses that could cause a default. To protect against these losses anticipatory collateral is posted.
Anticipatory collateral also follows the same lines as the trade interactions shown in FIG. 1A. However, unlike MTM collateral, both counterparties in a trading pair may be posting anticipatory collateral. For example, in a situation where A buys from B, A needs to provide B with anticipatory collateral to protect against the possibility of falling prices, while B needs to provide A with anticipatory collateral to protect against the possibility of rising prices. The exact level of anticipatory collateral is difficult to ascertain. The appropriate level of anticipatory collateral should protect against potential losses while not becoming so large that it is an oppressive burden. Anticipatory collateral levels are generally set at a point such that they will completely cover the potential loss 95% to 99% of the time. In the event of a default, the anticipatory collateral is used to lessen the total amount of the loss. For companies with positions having a very large positive value, no anticipatory collateral may be required as it would be unreasonable to expect to lose all of the accumulated profits over a short time period. However, in most cases both parties will be required to post anticipatory collateral, especially when both parties have future delivery or payment obligations, as in a long term futures contract.
In a situation where Company A and Company B are both posting collateral to cover the potential credit risk of their respective portfolios, a, collateralized default example can be illustrated. More specifically, if the following series of transactions occur:
(1) MTM collateral from Company B to Company A=$3 M;
(2) Anticipatory collateral from Company B to Company A=$4 M; and
(3) Anticipatory collateral from Company A to Company B=$2 M.
Currently, the position has moved in Company A's favor resulting in their receipt of mark to market collateral. In total, Company A has $7 M of protection and Company B has $2 M. If the next day, for example, the market moves in favor of Company B leading to a new MTM value of (−$2 M), Company B would be able to remove $1 M of their posted collateral. In addition, Company A may be required to increase the size of the anticipatory collateral that they are posting into the network 100 to cover their potential for larger losses now that the position is not as much in their favor. Alternatively, if the next day the market moves significantly against Company B leading to a new MTM value of (−$8 M), Company B would be required to post a total of $8 M of MTM collateral (i.e., $5 M of additional collateral). If Company B could not, it may be considered in default under the terms of party A and B's contract and any applicable trading system or exchange rules. Thus, this situation would be resolved by the following series of transactions:
(1) Company A receives the existing MTM collateral=$3 M;
(2) Company A receives the existing anticipatory collateral=$4 M; and
(3) Company B defaults on the remaining amount=1 M.
Note that in any transaction, the total of the three values of each step (1) to (3) must equal the total MTM value at the time of the default. Without anticipatory collateral in the event of a default, a counterparty is exposed to the entire size of the market move that has occurred since the last MTM collateral posting. Without MTM collateral, each company would be exposed to any change in value since entering the position.
To appropriately determine the size of the anticipatory collateral, the potential exposure of the position must first be identified. As is well known in the relevant art(s), the statistical measure of standard deviation, σ, is a common method of measuring the average distribution around a mean. By using a standard deviation of the value of an asset, the potential loss exposure can be calculated. This potential exposure can then be used to determine an appropriate level of anticipatory collateral.
The correct amount of anticipatory collateral should take into account the risk of an entire portfolio. Anticipatory collateral must therefore take into account the benefits of diversification. Diversification describes the principle of how risk tends to be reduced as an investment is spread across more assets. For example, an investment in a portfolio made up of two equally-risky assets will be less risky than the same sized investment in either asset alone. The size of the decrease in risk due to diversification will depend upon statistical relationships between the two assets.
Anticipatory collateral calculations that take into account portfolio diversification benefits are identical to those used to measure the “Value at Risk” of a portfolio. As such, any of the methods (e.g., variance-covariance, Monte Carlo simulation, historical) well known in the relevant arts that can be used to calculate Value at Risk can also be used to calculate anticipatory collateral. For this reason, Value at Risk measurements provide a good starting estimate of appropriate anticipatory collateral on an individual asset basis as well as on a portfolio basis. An in-depth discussion of calculating Value at Risk can be found in Jorion, Philippe, Value at Risk: The New Benchmark for Controlling Market Risk, Irwin Professional Pub. (Chicago, Ill.), 1997, ISBN 0786308486, and in J. P. Morgan, Riskmetrics Technical Document, available at URL: http://www.riskmetrics.com/rm/pubs/index.html, which are both incorporated herein by reference in their entirety.
There are two basic types of forward markets—futures exchanges and the over the counter (OTC) markets. The OTC market has been described previously and is represented by network 100. The futures exchange system is significantly different. In this type of system an exchange becomes the counterparty to every transaction (i.e., the buyer for every seller and the seller for every buyer). This simplifies the network of trades to a simple hub and spoke model system 200 as shown in FIG. 2. However, this simplification of the complex OTC network comes at the cost of a significant loss of flexibility in contract specifications. In addition, clearing houses for exchanges generally share the credit risk associated with default between and among its members. This process is known as “mutualization of risk.”
Collateral can be provided easily in futures markets as each company has only one counterparty—the exchange. However, many companies do at least some of their trading within the OTC market. In effect, the exchanges can be viewed as another counterparty in the OTC market. As previously discussed, the OTC market consists of many individual trading companies as represented in FIG. 1B. If each of these companies were to provide MTM and anticipatory collateral of sufficient size to each of its counterparties, it would lead to the necessity of posting very large amounts of collateral. These amounts of collateral would in fact be much larger than actually needed. The excess collateral arises because each pair of companies is only aware of trades directly between the pair and posts collateral based only on this knowledge. This leads to a complex network of bilateral collateral postings between counterparties (see FIG. 1B) and inefficient collateral usage. Referring to FIG. 3, an example of required MTM collateral postings for Company A is shown. In this example, Company A is receiving a total of $7 M in collateral (from B, E, and G), pays a total of $8 M in collateral (to C and F), and has no collateral transfer with Company D.
Only collateral postings for MTM positions are shown in FIG. 3. Company A, however, must also post anticipatory collateral to cover its potential exposures. This level is typically determined by each counterparty regardless of the MTM position of the trades with each company. Referring to FIG. 4, an example of required anticipatory collateral postings for Company A is shown. In this example, Company A must post a total of $11 M in anticipatory collateral (to companies A–G). Although not shown in FIG. 4, each of Company A's trading partners would also post anticipatory collateral to party A.
By providing collateral in this way, companies in a trading system are assuming the worst possible situation. That is, Company A is forced to: (1) post excess MTM collateral as it can not re-use the collateral posted to it; and (2) post excess anticipatory collateral because the diversification benefits of trades with different counterparties are ignored. Such inefficiencies and the resulting excessive collateral demands have been a factor in deterring some trading communities from requiring collateral. For example, consider a situation where Company A is short a certain position to F and long the same position to G. In such a case, the two trades should offset each other and thus require no collateral. However, as seen in FIG. 3 and FIG. 4, Company A is providing a total of $4 M in collateral to F and G.
Therefore, what is needed is a system, method, and computer program product for collateral management that determines the efficient amount of collateral posted by each member of a trading group. This trading group may consists of individuals, independent companies, and/or exchanges. This amount of collateral must be sufficient to protect against present losses and/or potential future losses due to the inability of that member to meet its obligations. The overall system, method, and computer program product should provide equivalent collateral protection as a fully collateralized bilateral system while decreasing individual collateral requirements.